The excess capacity series (red line) peaked in June of this year, and has been moving downward ever since. If the pattern in the two most recent recessions holds, those in 1990-91 and 2001, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity, i.e. around a year from today (though prior to 1990 the peaks were coincident).

The most recent data on the unemployment rate showed a downward tick from 10.2 percent to 10.0 percent, so perhaps unemployment has already peaked and the lag will be shorter this time. But perhaps not. As an inspection of the unemployment series in the graph shows, the unemployment rate bounces around even when it is trending upward or downward. So it's hard to tell from one month's data whether the downward tick in the unemployment rate is temporary and unemployment still has a ways to go before peaking (as in the last two recessions), or a sign that a turning point has been reached and things are getting better (which would represent a reversion to the more coincident movement in the two series observed before 1990).

Note, however, that in the 2001 recession, unemployment fell briefly just after excess capacity peaked, but then resumed its upward movement for several more months before reaching a turning point 19 months after the turning point in excess capacity. Thus, while the recent downward tick in the unemployment rate is good news, certainly better than an uptick, we should be prepared for the possibility that the pattern in the last recession might repeat itself and unemployment will head back upward for several more months before it reaches its peak. I hope that doesn't happen, the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I'd like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.

[Question: What happened from mid 1997 through the beginning of 1999 that caused the two series to move in opposite directions and separate?]

Hans-Werner Sinn is unhappy with the US financial system. He says "Europeans trusted a system that was untrustworthy," and that resulted in big losses for European banks:

Insecure Securities, by Hans-Werner Sinn, Commentary, Project Syndicate: ...For years, hundreds of billions of new mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) generated from them were sold to the world to compensate for the lack of savings in the United States and to finance American housing investment. Now virtually the entire market for new issues of such securities – all but 3% of the original market volume – has vanished.

To compensate for the disappearance of that market, and for the simultaneous disappearance of non-securitized bank lending to American homeowners, 95% of US mortgages today are channeled through the state institutions Fannie Mae, Freddie Mac, and Ginnie Mae. Just as there was a time when collateralized securities were safe, there was also a time when economies with so much state intervention were called socialist.

Most of these private securities were sold to oil-exporting countries and Europe, in particular Germany, Britain, the Benelux countries, Switzerland, and Ireland. China and Japan shied away from buying such paper.

As a result, European banks have suffered from massive write-offs on toxic American securities. According to the International Monetary Fund, more than 50% of the pre-crisis equity capital of Western Europe's national banking systems, or $1.6 trillion, will have been destroyed by the end of 2010... Thus, the resource transfer from Europe to the US is similar in size to what the US has spent on the Iraq war ($750 billion) and the Afghanistan war ($300 billion) together.

Americans now claim caveat emptor : Europeans should have known how risky these securities were when they bought them. But even AAA-rated CDOs, which the US ratings agencies had called equivalent in safety to government bonds, are now only worth one-third of their nominal value. Europeans trusted a system that was untrustworthy. ...

For years, the US had a so-called "return privilege." It earned a rate of return on its foreign assets that was nearly twice as high as the rate it paid foreigners on US assets. One hypothesis is that this reflected better choices by US investment bankers. Another is that US ratings agencies helped fool the world by giving triple-A ratings to their American clients, while aggressively downgrading foreign borrowers. This enabled US banks to profit...

Indeed, it is clear that ratings were ridiculously distorted. While a big US rating agency gave European companies, on average, only a triple-B rating in recent years, CDOs based on MBSs easily obtained triple A-ratings. ... And according to an NBER working paper by Efraim Benmelech and Jennifer Dlugosz, 70% of the CDOs received a triple-A rating even though the MBSs from which they were constructed had just a B+ rating, on average, which would have made them unmarketable. The authors therefore called the process of constructing CDOs "alchemy," the art of turning lead into gold.

The main problem with US mortgage-based securities is that they are non-recourse. A CDO is a claim against a chain of claims that ends at US homeowners. None of the financial institutions that structure CDOs is directly liable for the repayments they promise...

Only the homeowners are liable. However, the holder of a CDO or MBS would be unable to take these homeowners to court. And even if he succeeded, homeowners could simply return their house keys...

The problem was exacerbated by fraudulent, or at least dubious, evaluation practices. ... The US will have to reinvent its system of mortgage finance in order to escape the socialist trap into which it has fallen. A minimal reform would be to force banks to retain on their balance sheets a certain proportion of the securities that they issue. That way, they would share the pain if the securities are not serviced – and thus gain a powerful incentive to maintain tight mortgage-lending standards.

An even better solution would be to go the European way: get rid of non-recourse loans and develop a system of finance based on covered bonds, such as the German Pfandbriefe . If a Pfandbrief is not serviced, one can take the issuing bank to court. If the bank goes bankrupt, the holder of the covered bond has a direct claim against the homeowner... And if the homeowner goes bankrupt, the home can be sold to service the debt.

Since their creation in Prussia in 1769 under Frederick the Great, not a single Pfandbrief has defaulted. Unlike the financial junk pouring out of the US in recent years, covered bonds are a security that is worthy of the name.